Bonds

A bond is a loan or a debt between bond issuer (borrower) and bond holder/owner (lender). Like a loan or debt, a bond must be paid back with interest or at some rate of return. A bond holder, obviously, has no ownership interest in bond issuer - unlike a stock holder/owner.

Federal government agency bonds - such as Small Business Administration, the Federal Housing Administration and the Government National Mortgage Association (Ginnie Mae) - there bonds are typically backed by the ‘full faith and credit’ of U.S. government.

Government Sponsored Entities bonds - such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae) and the Federal Home Loan Banks provide credit for the housing sector and Federal Agricultural Mortgage Corporation (Farmer Mac).

State and municipal bonds - these can be in form of “revenue bonds” or “general obligation bonds”

Corporate bonds - issued by corporations such as General Electric.

A bond is at face value (or par value) - usually $1,000 or $5,000. The bond issuer promises to pay bond holder the face value or principal at some specified future date known as the maturity date. To compensate the bond holder for paying principal at maturity date, issuer agrees to pay interest to bond holder at some coupon rate.

For example, let’s say you buy four - 10 year bonds at face value of $1,000 and pay 6% coupon rate. As a bond holder, you would receive $240 per year for 10 years and then receive $4,000 on the maturity date. Now, this example assumes a fixed coupon rate but many bonds have a floating rate - a coupon rate tied to some index rate such as London Interbank Offer Rate (LIBOR).

Now, the above example as assumes you buy bond in primary market or initial offering. But most bond investors buy bonds in the secondary market or bond market. This is where bond prices become relevant because bond prices do fluctuate over time. Bond pricing can be tricky for someone new to bonds. Let’s start with pricing convention - bond are priced as a percentage of par value. For example, you might see a quote in Bloomberg for 101-19 (dash or colon represents 32nds of a dollar for 10 year Treasury Note, this means the bond price is 101-19/32% of $1,000 or $1,015.94. In this example the bond price was above par value (101-19) this is known as a premium. Bonds trading below par value (say 99-27) are trading at a discount.

There are a number of factors that effect the price of bonds including issuer’s credit rating, inflation expectations, supply/demand of debt issues, and economic outlook. These factors and a few others such as reinvestment risk are reflected in market yield or bond yield. Generally, bond investors demand higher market yield or bond yield to compensate for higher risk. And this is where it sometimes gets tricky but it’s very important to understand: Bond price and market/bond yield have an inverse relationship - when market/bond yield goes up, bond price decreases; and when market/bond yield goes down, bond price increases.

So much for an introduction. Any questions?

Like all investments, before investing make sure we understand what we are getting ourselves into. For information on investing in bonds - check out - InvestinginBonds.com. Good luck.

July 14, 2011

Very Important Tip

I don’t normally watch TV but this morning it was on ABC’s Good Morning America. GMA had a segment with its financial correspondent, Mellody Hobson. She was talking about things in our wallets - what to carry and not to carry. She offered some very good suggestions but there was one that really stuck out.

If your wallet is ever lost or stolen someone with bad intentions has your entire identity at their disposal - name, home address and social security number. They can do a lot of damage with that information. It was only a few years ago when I started not carrying my SS card in my wallet. It is something that we often overlook but with identity theft a huge ‘black market’ industry we can no longer afford to.

2 Most Important Pieces of Investment Advice

Someone asked me over the weekend what I thought were the two most important pieces of investment advice. Just two? Ok, well below was my response.

This was a very tough question because obviously there are a lot of very important things to understand when it comes to investing.

1) Understanding the concept and relationship of risk and return. Riskier assets such as stocks and most real estate require a higher return or yield to compensate for the risk taken. Also, watch out if some snake oil salesman says he can get you a risk-free high return - just not true. High risk - high return and low risk - low return.

2) Understand the investments. This means a thorough understanding. It doesn’t matter if its a mutual fund, an exchange traded fund (ETF) or stock. And it doesn’t matter that a financial advisor has recommended something. Know where and what your hard earned money is going into because it may not be what you like or are comfortable with (despite potential for high return).

I can’t pass up the opportunity to add two more pieces of investment advice - that’s just how I roll:

3) Consistency is important. This means making investing a habit or routine - whether on a monthly basis or quarterly basis.

4) Understand your risk tolerance. No one can tell you what your risk tolerance is. This is a very subjective thing. Once you understand your risk tolerance don’t stray away from it no matter how attractive an investment may be.

How about you? What other investment advice do you have?

May 11, 2011

The Poor Get Swiped by Swipe Fees, the Rich Make Bank

This week’s credit check: Consumers overall pay up to $48 billion more a year because of swipe fees. Low-income households end up paying $23 because of them while high-income households receive $756 every year.

Whenever I bring up the predatory bank practices that keep people stuck in debt, usually the first push back I get is that credit cards can be useful. Cards with rewards are a way to get things in return for spending money; if you open an account with cash back or rewards programs, some people point out, and you pay down your balance every month, you’re basically getting something for nothing from your card company (unless of course the account has an annual fee). On the surface this is true, but dig a little deeper and it’s not quite that simple. Strictly speaking, the money to finance these goodies comes from merchants big and small who are charged outsized fees every time a card is swiped, fees they have literally no power to negotiate over or change whatsoever. But the reality is that the costs get passed on further to consumers — all consumers, in a very regressive way.

Zach Carter and Ryan Grim have written a fantastic, long-read article on the battle over swipe fees raging on Capitol Hill. Because this is a little-covered fight, here are the basics: as part of the Dodd-Frank financial reform bill, a cap was to be put on how much a bank can charge a merchant each time it swipes a customer’s debit card. (Banks successfully lobbied to keep credit cards out of the picture altogether, so those fees will continue either way.) That charge is called an interchange or swipe fee. Banks used to charge merchants about 44 cents per transaction, but under the new rules that would be capped at 12, costing the big banks about $14 billion in fees per year. (As RJ Eskow points out, compare that profit loss to the $20 billion in bonuses banks gave themselves last year.) But since the date for implementation of this rule has neared (it was supposed to be finalized on April 21 and in effect by July 21), it has been pushed back and is now under heavy attack from — you guessed it — Wall Street lobbyists.

One major takeaway from Carter and Grim’s article is that the current fight is in many ways between big corporate interests and other big corporate interests — i.e. the Wal-Marts and Targets vs. the Bank of Americas and Citigroups. But beyond that fight, there’s another battle that we think very little about: these fees pit rich against poor.

Steve Pearlstein explained how we got to a point that card companies can fleece merchants and consumers: “Visa, Mastercard and American Express now account for more than 90 percent of the market. And with that much concentration comes the power to charge higher prices than would be possible in a market with many competitors.” Our interchange fees in the US are higher than in any other industrialized country. And those higher prices are passed on to consumers through higher prices on the products that the overcharged merchants sell. These price hikes amount to up to $48 billion more a year that we pay on gas, groceries, entertainment, you name it. The banks claim that they need to charge fees to balance out the risk of lending through credit cards, but since we’re only focused on debit cards in this debate — which don’t lend to customers, but merely let them access the money sitting in their own bank accounts — that point would appear moot. Not to mention that a debit transaction only costs a few pennies. One of the banks’ claims is that this cap will kill small banks and credit unions — which ignores the fact that Dodd-Frank exempted those with less than $10 billion in assets. Not to mention that of the $16 billion in fees, half of that — $8 billion — ends up at just 10 banks.

But when these costs get passed on in the form of higher prices for the things we want and need, it turns out that the poor pay up while the rich make off with rewards. Carter and Grim’s article points to a February 2010 paper that found that 56% of fees are passed on to consumers, “raising costs for the average household by about $230 a year.” That amounts to “two weeks worth of groceries or the monthly heating bill” for a family living below the poverty line. But it gets worse for low-income families. From their article: “[W]hile swipe fees cause higher prices for everyone, affluent consumers get some of that money back in the form of rewards. The result is an effective transfer of wealth from poor shoppers to wealthier consumers.” In fact, the Boston Fed has found that, “On average, each cash-using household pays $151 to card-using households and each card-using household receives $1,482 from cash users every year.” Some cash holders might be those who refuse to use plastic, but a lot of those are likely to fall into the category of the unbanked. The study further found:

Because credit card spending and rewards are positively correlated with household income, the payment instrument transfer also induces a regressive transfer from low-income to high-income households in general. On average, and after accounting for rewards paid to households by banks, the lowest-income household ($20,000 or less annually) pays $23 and the highest-income household ($150,000 or more annually) receives $756 every year.

As Carter and Grim point out, this fee cap isn’t likely to stop banks from issuing debit cards, and there doesn’t seem to be any good reason for them to start charging fees left and right to make up for the profit loss. As they quote Senator Dick Durbin, sponsor of the amendment that sought to cap the fees in the first place, as saying, “There is no need for you to threaten your customers with higher fees when you and your bank are already making money hand over fist. And there is no need to make such threats in response to reform that simply tries to spare consumers.” It’s even less defensible when the fees are so clearly a wealth transfer from the poorest to the richest.

Great Advice on Budgeting

Please read the whole article. It has some good forms at the end. The key points:

The first rule of budgeting: Don’t worry about perfection.

The second rule of budgeting: The big stuff makes more difference than the small stuff.

The third rule of budgeting: Make plans based on your real life, not how you wish life would be.

The fourth rule of budgeting: Keep it simple.

Get out Debt First - think “hot potato”.

It is extremely difficult to get anywhere without a plan. A budget is a form of a very important plan. It’s one of those ‘necessary evils’ if we want to improve our economic security. Budgeting is not difficult - it just takes some time and discipline - not impossible.